The buy-side Quality of Earnings team is calculating our normalized net working capital using a simple twelve-month average, but this ignores our strategic investments in custom inventory and prepaid software licenses. How do we defend our working capital definition to protect our cash at close?

Question

Tyler Smith · Accepted Answer

A simple twelve-month average of net working capital will often penalize growing, efficient businesses. If you have recently upgraded your operating systems or prepaid annual software licensing fees to drive automation, those cash outflows are already delivering economic benefits that the buyer will enjoy post-close. Under valuation standards like IVS 105, you must adjust your net working capital definition to reflect the actual operational requirements of the business, not a generic historical average. Start by conducting your own sell-side Quality of Earnings analysis. Identify any non-recurring prepaid expenses, custom inventory investments, and deposits that do not reflect normal daily operations. Present these as adjustments to normalize the working capital target, also known as the peg. If you do not adjust for these, you are essentially gifting the buyer free cash flow on day one. Align this financial defense with your operational model. Show the buyer how your prepaid assets directly lower the monthly operating expenses they will inherit. In your negotiations, argue that since these investments are already paid for, they should either be excluded from the net working capital target or reimbursed as cash additions to the purchase price. Keep your leadership team focused on tracking inventory turns and accounts receivable in your weekly Level 10 Meeting™ to ensure your working capital stays tight and predictable during the diligence process, preventing the buyer from claiming your cash requirements are highly volatile.